February 2022
Examining recent market volatility
Hello and welcome to our latest investment update. This month we're taking a look at the recent volatility in the market and what this means for investors. We hope, as ever, you find it useful and informative. Our thanks to our partners at Charles Stanley for their help in pulling the content together.
Equity markets have recently experienced an increase in volatility – and we should not expect this to end any time soon. Equity valuations remain elevated and central bankers have a challenging balancing act as they try to dampen a problematic rise in inflation without derailing the economic recovery from the pandemic.
The Chicago Board Options Exchange’s CBOE Volatility Index – known simply as the Vix – is the main measure used to assess market expectations of stock market volatility. The upward trend in recent months can clearly be seen in Chart 1, although it remains well below the level seen at the start of the pandemic in 2020. This rise has been driven by a pivot by central bankers to a more-aggressive stance on inflation. Financial conditions are about to be tightened at a faster rate than the market expected at the end of last year and concerns are escalating that these will be tightened too fast.
These concerns have resulted in an increase in hedging activity and profit taking by institutional investors in order to trim their equity exposure. They use financial derivatives such as options to take positions that act as a form of insurance against a fall in stock markets, as they can benefit as the value of the underlying asset falls.
Chart 1 | Vix index (source: Bloomberg)
Given the sharp rise in equity prices over the last few years, many institutions are likely to take the opportunity to trim their equity holdings and bank some profits. As you can see in Chart 2, valuations on the S&P 500, expressed in forward price earnings multiples, are currently one standard deviation above average levels over the last 25 years. Unprecedented monetary and fiscal stimulus that was deployed to smooth the effects of the pandemic have helped prop up valuations at this level. But this support is now about to be removed, albeit at a measured pace. Governments and central banks have made it clear that these policies are now going into reverse – so this will no longer provide a tailwind for risk assets.
The other characteristic that has played out recently has been the significant impact on companies that have missed market earnings expectations – or those that have provided a less-than-rosy outlook. Facebook-owner Meta Platforms is probably the most notable, with concerns around rising competition and regulation resulted in its market value shrinking by more than a quarter in just one day. PayPal was another major US group that lost more than 25% of its valuation immediately after its management cut its revenue guidance. At the time of writing both share prices remain near those recent lows.
Countering this have been announcements from companies such as Apple and Amazon, which have at least met expectations and have maintained greater price stability. We believe that the greater stock dispersion (variability of returns across different stocks in an index) is a trend that could continue in the medium term as investors become more focused on company-specific issues, as opposed to the macro-economic elements that have been a key driver for risk appetite for the last few years. This means good share selection is increasingly important.
Chart 2 | S&P 500 forward price earnings multiple with standard deviation bends (source: Bloomberg)
POLICY HEADWINDS
The central banks, which have been running emergency stimulus and liquidity initiatives during the pandemic, will be looking to “at least” normalise policy settings over the short to medium term. This will be a headwind for markets, as investors increasingly focus on comments and announcements from the central bank committee members to assess how aggressively interest rates will rise and quantitative-easing (QE) measures will be removed. This will be very dependent on inflation indicators and underlying economic demand measures.
Chart 3 | Core Inflation Chart (source: Bloomberg)
We have not seen core inflation levels in key regions this high since the early 90s, so central banks are now dusting off their inflation-controlling procedures. Much of the worry about core inflation (excluding food and energy) stems from supply-chain issues increasing costs for companies. Businesses that have seen a margin-damaging rise in costs have mostly been able to pass these price rises onto consumers, as the demand for goods has been strong. However, this issue is something we are watching carefully, both from the perspective of ongoing inflationary pressures – but also for specific company earnings.
Central banks can’t really fix the world’s supply-chain problems, so they will be watching closely to see if these concerns alleviate over the next few months. In the interim, their main objective will be to manage inflation expectations over the medium term – and, perhaps more importantly, communicate their intentions well.
It’s not just market professionals that central banks need to convince. If people see the current spike in inflation as structural, it may force workers into pushing for higher wages so central bankers have to get their message through to the public at large too.
The services sector comprises a large portion of the core inflation measures that are monitored and wages are a key driver of inflation in this part of the economy. If wages start to escalate to compensate for higher consumer prices, it creates a compounding effect on overall inflation. This explains why Bank of England Governor Andrew Bailey asked for wage-rise restraint in a recent speech.
We are seeing signs of higher wage inflation, particularly in the US, but it has not embedded itself at this stage. Clearly, it is something we will be watching very closely as it will help to determine how high interest rates need to go to keep inflation under control.
Chart 4 | Central Bank Rates (source: Bloomberg)
Markets have already priced in an aggressive reversal of pandemic support measures over the next 12 months. However, the balance sheets at central banks have grown substantially over the pandemic, as QE, which was designed to keep long term interest rates low, resulted in an unprecedented level of asset purchases.
QE was achieved through the purchase of bonds, both government and corporate, and asset-backed securities in the market. The unwinding of these positions will start by allowing securities to mature, with the proceeds not being reinvested. This will be followed up by active selling of these securities.
The result of this quantitative tightening (QT) will be to remove the excess liquidity from the financial system. There may be some significant market implications as these pandemic economic props are removed. QE has been one of the main drivers of asset prices such as housing and equities over the last couple of years. Again, it is the speed at which central banks look to reduce their balance sheets that will determine the market’s reaction to these inevitable events.
So, central banks need to act and the priority for them to control inflation is now well-telegraphed. One of the key features when the Federal Reserve began raising rates in 2016 (Chart 4) was the gradual implementation and emphasis on assessing the impact of the tightening of financial conditions on economic activity. Admittedly, today’s inflationary concerns were absent, but it highlighted the fact that the Fed was keen to understand the sensitivity to tighter policy – and get a better understanding of where “neutral policy” (neither restrictive nor stimulatory) could be found.
We would expect to see a lot more conjecture on this from market commentators over the next few months.
Given the fragility of the economy as it recovers from the pandemic and the associated restrictions, it is difficult to see central bankers wanting to grind the economy to a halt to control inflation. If market expectations are realised it will not allow enough time to fully consider the impacts and sensitivity on how it is affecting the overall economy. This means it is likely that markets could over-react to expected changes in policy. This necessitates a constant assessment of what actions have been priced into the market so they can be compared with our own views on the economic and market outlook. This will allow us to manage risk, but it may also highlight opportunities to buy into quality companies at an attractive valuation.